Carole B Inc. and Doc A Inc. are both operating in the amusement and animal park industry. Both companies have identical projects that will generate free cash flows of either $1 million per year going forward if the economy is doing poorly, or $2 million per year if the economy is doing well, with equal probability. Carole B Inc. has no debt, and Doc A Inc. has $10 million in perpetual debt outstanding, on which it is paying 6% interest per year. Suppose that there are no taxes, and after paying any interest on debt, both companies use all remaining free cash flows to pay dividends each year.
Assume everyone has access to perfect capital markets. a) What are the payments that debt and equity holders of Carole B Inc. and Doc A Inc. will receive per year in each state of the economy? b) Suppose you own 25% of the outstanding equity of Carole B Inc. (and nothing else) but you just found out some information about Carole B Inc. and you do not want to invest in the company any longer. Instead you would like to invest in Doc A Inc. Construct a portfolio that would provide you with the same cash flows as your current investment. Note: Show your work in detail.
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